Energy Markets: The Past is Not Always the Key to the Future

Sometimes it is useful to take a look at the bigger picture, or a completely different picture, when trying to assess the vibe (man) of a certain market (i.e., energy), especially given some of the negative vibes swirling in markets at the moment. As regular burrito readers know, the foundation of this blog is built on the belief that financial markets influence and are influenced by each other. Therefore, by taking a look at current trends in equities, commodities, bonds, economic data, and currencies – basically everything but energy – it can help us get a more rounded view on the subject that is most dear to us.

So first up is economic data and equities, as the S&P 500 has just reached a 5-year high. As the US economy is seeing slow but steady improvement (fiscal cliff avoided, Euro debt crisis fears allayed for now), stocks have continued to rise as economic data and general sentiment have shown modestly positive momentum.

The chart below sums up the inter-relationship between equities and economic data rather nicely, as equities have risen in the last few years concurrently with a fall in weekly jobless claims (which is inverted below). As equities hit a five-year high, improving job prospects mean claims have now fallen to their best rate in…yep, five years.

Next up is a chart which plots two seemingly unrelated assets which show a surprisingly strong relationship. This chart plots the Japanese Yen exchange rate (versus the US dollar) and the yield on 5-year Treasuries (US government debt). The Japanese Yen has been in the process of strengthening over the past few years as the Japanese population repatriates its savings. This generally happens during times of strife, indicating a flight to safety. The same logic exists for US Treasuries – historically a falling yield (ergo, higher prices) signifies a flight to safety.

However, in the unprecedented times we live in, the low yield on US government debt is not only indicative of a flight to safety, but of both a near-zero interest rate environment and the artificial impact of quantitative easing (QE1,QE2, QE∞). Yet while the 5-year Treasury yield is showing minor upside of late as future interest rate hikes gradually get priced in, a new Prime Minister in Japan and the expected announcement of further stimulus (which has been duly delivered) has seen the Yen selling off like a mad thing in recent weeks, sending it to a level not seen in two-and-a-half years. The relationship betwixt the two, albeit for now, looks one of temporary separation.

Lastly we take a look at a chart we scrutinized a mere five months ago, but given a rather dramatic turnaround in its composite, it seems worth revisiting. Chinese equities and iron ore prices were both in a downward spiral last August as the Chinese Government’s attempt to cool its economy was coming to fruition.

However, the final quarter of last year saw China’s transition to a new leadership, and renewed stimulus efforts to boost its economy. As recent economic data comes in better than expected, and higher consumption and imports of commodities is seen, both Chinese stocks and iron ore prices have been ripping higher, indicative of both renewed activity and optimism.

Sometimes it is easy to get stuck in a mindset, taking a view from the past and carrying it forward, even though the facts may have changed. This is known as cognitive dissonance: having inconsistent beliefs.

This is my reason for highlighting these charts. Although I am by no means a raging bull on the global economy – far from it – ignoring such positive indicators would be an injustice. The global economy may face headwinds in 2013, but we must acknowledge these bullish signals across various regions and markets, as they likely point to higher global energy demand going forward; some food for thought before becoming too wrapped up in some of the negative vibes, man.